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1 THE JOURNAL OF FINANCE VOL. LV, NO. 3 JUNE 2000 When the Underwriter Is the Market Maker: An Examination of Trading in the IPO Aftermarket KATRINA ELLIS, RONI MICHAELY, and MAUREEN O HARA* ABSTRACT This paper examines aftermarket trading of underwriters and unaffiliated market makers in the three-month period after an IPO. We find that the lead underwriter is always the dominant market maker; he takes substantial inventory positions in the aftermarket trading, and co-managers play a negligible role in aftermarket trading. The lead underwriter engages in stabilization activity for less successful IPOs, and uses the overallotment option to reduce his inventory risk. Compensation to the underwriter arises primarily from fees, but aftermarket trading does generate positive profits, which are positively related to the degree of underpricing. INITIAL PUBLIC OFFERINGS OF SECURITIES are among the most important events in capital markets. By providing access to public markets, the IPO is both the conduit for new capital to flow to fledgling companies and the mechanism for the existing owners to realize a return for their efforts. 1 The lead underwriter plays an important role in pricing and distributing an IPO, certifying the quality of the issue by his past performance in IPO underwriting. 2 However, the importance of the underwriter continues beyond the IPO date, when he becomes a market maker for the newly traded stock. This paper is the first direct examination of the trading activity of the lead underwriter in the IPO aftermarket. * Australian Graduate School of Management, Cornell University and Tel-Aviv University, and Cornell University, respectively. The authors thank Dean Furbush, Tim McCormick, and Jennifer Drake of the NASD Economic Research Department for their extensive help in providing the data set in this paper. We also thank Sandie Daignault of BT0Alex Brown, Gustavo Grullon, Ananth Madhavan, Manju Puri, René Stulz, Sarah Tasker, Elizabeth Odders-White, Kent Womack, Jaime Zender, an anonymous referee, and workshop participants at Cornell University, Duke University, the London Business School, New York University, Rice University, the University of Melbourne, the University of New South Wales, the University of Queensland, the University of Sydney, the University of Technology, Sydney, the NBER Corporate Finance meeting, and the 1999 Winter Finance Conference for helpful comments. 1 That IPOs are typically underpriced, for example, is a well-known phenomenon, as is the fact that IPOs are often oversubscribed. See, for example, Rock ~1986!, Allen and Faulhaber ~1989!, Welch ~1989!, and Benveniste and Spindt ~1989! for theoretical treatments of the issue, and Ibbotson ~1975!, Ritter ~1991!, and Hanley ~1993!, among many others, for empirical evidence. For an excellent review of general IPO issues, see Ibbotson and Ritter ~1995!. 2 For evidence on the relation between the reputation of the underwriter and IPO performance see Beatty and Ritter ~1986!, Carter and Manaster ~1990!, and Michaely and Shaw ~1994!. 1039

2 1040 The Journal of Finance Other research has examined aspects of the post-issuance activities by underwriters and other market participants. Schultz and Zaman ~1994! examine the quotes of lead underwriters in the first three trading days after the IPO. They find that underwriters generally quote the highest bids and so actively support the price of less successful IPOs. Hanley, Kumar, and Seguin ~1993! also find evidence that the lead underwriter engages in stabilization. 3 Using a proprietary database on short covering transactions by syndicate members, Aggarwal ~1998! provides evidence that underwriters use extensive short positions to provide price support for new issues. Michaely and Womack ~1999! investigate the linkage between underwriting activity and post-issuance buy recommendations, finding that underwriters issue more buy recommendations than nonunderwriters and that those recommendations are positively biased. These papers provide compelling evidence that the components of the IPO process are not distinct entities, and that the underwriter has a role that goes beyond the offer date. In this paper we investigate the aftermarket trading of Nasdaq IPOs. Of particular importance for IPOs brought to the market on Nasdaq is that the underwriter can become a market maker, providing a potential link between the before-market pricing and syndication functions with the aftermarket trading and stabilization activities. 4 Our research is made possible by a unique database of all trading data for 306 IPOs on Nasdaq for the period September 1996 to July These data provide time-stamped bid and ask quotes, signed trades, trade sizes, and dealer identities, allowing us to calculate who sets the market quotes, who trades with whom, how much inventory each dealer takes, the prices at which he trades, and the profits each dealer makes. Combining this information with data on fees and underwriter and comanager identities from the Securities Data Company ~SDC! Global New Issues Database, along with data on overallotment usage from issuers 10Q and 10K filings, we are able to investigate the particular roles played by the underwriter and the co-managers in the aftermarket behavior of an IPO. An implicit, and at times even explicit, part of the contract between underwriters and issuers in an IPO is that the underwriter will provide liquidity in the post-issuance trading of the newly traded security. We examine this aftermarket trading with three questions in mind: First, how do the underwriters and the co-managers behave in the aftermarket trading of the IPO? Do underwriters and co-managers indeed provide liquidity for the newly traded IPO? Who else makes markets for IPOs? Second, how much inven- 3 See also Prabhala and Puri ~1999!. Evidence on the use of the overallotment option can be found in Carter and Dark ~1990!, Muscarella, Peavy, and Vetsuypens ~1992!, Hanley, Lee and Seguin ~1996!, and Aggarwal ~1998!. 4 Nasdaq ~for the National Association of Securities Dealers Automated Quotation system! is the traditional venue for the taking public of smaller companies, and in 1996 a total of 655 IPOs took place on the Nasdaq. By comparison, in 1996 the New York Stock Exchange had 279 original new listings. For IPOs on the NYSE, the underwriter may still exercise a price support role, but since he is not the stock s specialist, this is accomplished through his submitting limit and market orders. Unfortunately, our data contain only Nasdaq IPOs so a comparison of underwriters behavior between IPOs issued on the two exchanges is not feasible.

3 An Examination of Trading in the IPO Aftermarket 1041 tory risk does the lead underwriter ~and other market makers! take in the period after the IPO has began trading? Fundamental to this analysis is the role of inventory, and our research here provides the first in-depth picture of the inventory positions taken by the underwriter and other market makers over the first 60 trading days of an IPO. The inventory exposure of the market maker can entail substantial risk, particularly for new issues. Our data set allows us to examine this risk, and in particular how the underwriter0 market maker s inventory exposure and actions differ with respect to the size of the issue, with its subsequent performance in the market, and with the use of the overallotment option. Third, is post-ipo trading a cost center, subsidized by the fees generated from the underwriting activities, or is it a significant profit activity that makes underwriting even more lucrative? By analyzing all of the trades of each syndicate member, we are able to determine the cash inflows and outflows for each account, and thus the trading and inventory profits, of the underwriter and the other market makers. Our research provides a number of new results on the IPO process. We highlight four of them here. First, we find that the lead underwriter always becomes a market maker in the issue, and in fact becomes the most active dealer. On average, the lead underwriter handles about 60 percent of the trading volume in the first few days after the stock begins trading, and about 50 percent of the total volume when measured over the first few months of trading. This result establishes an important link between the premarket and aftermarket behavior of the underwriter. We also find that co-managers are not active liquidity providers for the IPO, and that their trading and inventory position are not significantly different from those of other market makers. Thus their role as market makers is small. Second, we find that the lead underwriter0market maker takes substantial inventory positions in the stock, accumulating on average four percent of the stock offered in the issue after the first day of trading. The inventory accumulation by the underwriter is especially large when the newly traded security has been trading below the offer price. In those instances, the average inventory position of the underwriter can reach over 22 percent of the issue. Thus, price support activity potentially exposes the underwriter to a significant amount of inventory risk. However, we also show that institutional features such as the standard 15 percent overselling of the issue at the offering day, combined with the overallotment option, greatly reduce these inventory risks. Thus, features like the overallotment option not only give flexibility to the firm and the underwriter in determining the issue size, but also facilitate stabilization activities and liquidity provision by the lead underwriter. Third, we find that most of the compensation for the IPO arises from underwriting fees, with trading profits and inventory profits contributing less than 23 percent of the underwriter s overall profits after three months of trading. Thus, in the period immediately following the offering, aftermarket trading is not a significant source of profits to the underwriter relative to the fees generated from underwriting. It is not the case, however, that providing liquidity and stabilizing the issues in the aftermarket are subsi-

4 1042 The Journal of Finance dized by the underwriting activities. Both trading revenues and fees contribute to underwriter profits, so on average the aftermarket trading activities cannot be viewed as a cost to the underwriter connected with the IPO process. These findings are in contrast to the assumption made by Benveniste, Busaba, and Wilhelm ~1996! and Chowdhry and Nanda ~1996! that stabilization activity is costly to underwriters. 5 Fourth, we find a significant link between underwriters trading profits and IPO underpricing. This link suggests that IPO underpricing may be at least partially due to the integrated nature of the IPO process in that the underwriter directly benefits from underpricing the issue. We interpret these results as showing that the economic linkages of the IPO process give underwriters an added incentive to underprice issues. The paper is organized as follows. In Section I we briefly outline the mechanics of the IPO process, with particular attention given to the differing activities of the underwriter after the IPO has begun trading. In Section II we describe our database and investigate the basic issues of who underwrites and who makes markets in IPOs. We examine the trading volume and turnover of new issues with a particular focus on the trades of the underwriter and other syndicate members. In Section III, we examine this trading behavior in more detail by calculating inventory and trading profits and losses of IPO underwriters and market makers. We also investigate the link between these variables and IPO characteristics and performance, allowing us to investigate potential price stabilization activities by the underwriter. In Section IV we consider the profitability of IPO underwriters and market makers, and we investigate how IPO performance affects this profitability. The paper s final section summarizes our results, discusses their implications for IPO and market maker behavior, and outlines areas for future research. I. An Overview of the Public Offering Process Table I briefly outlines the steps involved in the going public process. The first step involves the choice of the deal book-running manager and the co-managers ~if any!. The lead manager is also responsible for assembling the syndicate to assist in the sale of the shares to the public. One of the lead underwriter s first-agenda items is to draft a letter of intent. Among other issues, the letter contains clauses protecting the underwriter against any uncovered expenses in the event the offer is withdrawn, the percentage of gross spread as a function of the proceeds ~almost always seven percent, see Chen and Ritter ~2000!!, and a commitment by the company to grant a 15 percent overallotment option to the underwriter. At this stage the underwriter starts the due diligence process in which the underwriter reviews the issuer s financial statements, talks with management, customers, and suppliers, and starts to plan the structure of the deal. 5 It is important to note, however, that our profits calculations are for the entire market trading activities and not for the stabilizing bids in isolation.

5 An Examination of Trading in the IPO Aftermarket 1043 Concurrent with the due diligence process, the company and its counsel draft the registration statement for filing with the SEC. The Securities Act of 1933 makes it illegal to offer or sell securities to the public unless they have first been registered. Once the registration statement is filed with the SEC, it is transformed into the preliminary prospectus ~or Red Herring!. The preliminary prospectus is one of the primary tools in marketing the issue. The marketing of the offering begins following the filing of the registration statement with the SEC. The Red Herring is sent to the sales people as well as to institutional investors around the country, and at the same time the company and the underwriter promote the IPO through the road show. As the road show progresses, the underwriter receives indications of interest from investors. At this stage, prior to the effective day, no shares can be officially sold, so any orders submitted are only indications of interest and are not legally binding. On the day prior to the issuance date, after the market closes, the firm and the lead underwriter meet to discuss the final offer price and the exact number of shares to be sold. Particular attention during the pricing decision is given to the order books where institutions and other investors indications are recorded. After those final terms are negotiated, the underwriter and the issuer execute the Underwriting Agreement, the final prospectus is printed, and the underwriter files a price amendment on the morning of the chosen effective date. Only at this point is the underwriter committed to sell the securities at the agreed upon price. Once approved, the distribution of the stocks begins. The lead underwriter and the rest of the syndicate members distribute the stock to their customers. In most cases, the managing underwriter overallots the issue, creating a short position by accepting more orders than there are shares to be sold. On this morning, the company s stock opens for trade for the first time. But the IPO is far from being completed. Once the issue is brought to market, the underwriter has several additional activities to complete. These include the decision on whether to use the overallotment option, the aftermarket stabilization obligations, and the provision of analyst recommendations. The overallotment option ~known as the green shoe! grants an option to the underwriter to purchase from the company, within 30 days, an additional 15 percent of the shares sold in the IPO at the offer price. ~The NASD sets the 15 percent limit for the green shoe option.! With this option, an underwriter can ~and virtually always does! sell 115 percent of the firm s shares at the offering. 6 The motivation for this option is to provide buying support for the shares without exposing the underwriter to excessive risk. If the offering is strong and the price goes up, the underwriter covers his short position by exercising the green shoe option at the offering price ~and receives an additional gross margin of typically seven percent on the proceeds from the overallotted shares!. If the offering is weak and the price goes down, the underwriter does not exercise the option, and instead buys back all or part of the extra 15 percent of shares in the market, thereby support- 6 Note that this option can be exercised solely to cover overallotted shares at the offering.

6 1044 The Journal of Finance Table I Description of the IPO Process Major Stages and Main Events 1. Initial step Select book-running manager and co-manager Letter of intent Role of the Underwriter in the Main Events Selection is a function of the investment banker s reputation, expertise, and quality of research in the specific industry. The book-running manager s role includes forming the syndicate and being in charge of the entire process. This initial agreement between the underwriter and the issuer protects the underwriter against any uncovered expenses in the event the offer is withdrawn, it specifies the gross spread ~usually seven percent!, and it contains a commitment by the company to grant a 15 percent overallotment option to the underwriter. There is no guarantee of the final offering price or the number of shares to be issued in the letter of intent. The letter of intent remains in force until the Underwriting Agreement is executed at pricing. 2. Registration process Registration statement and due diligence Red Herring The Securities Act of 1933 mandates that the company and its counsel draft a registration statement for filing with the SEC. The purpose of the registration and disclosure requirements is to ensure that the public has adequate and reliable information regarding securities that are offered for sale. To achieve this, the underwriter has a due diligence requirement to investigate the company and verify the information it provides about the company to investors. The Securities Act also makes it illegal to offer or sell securities to the public unless they have first been registered. Once the registration statement is filed with the SEC, it is transformed into the preliminary prospectus ~or Red Herring!. The preliminary prospectus is one of the primary tools in marketing the issue. 3. Marketing Distribute prospectus; road show The Red Herring is sent to sales people and institutional investors around the country. Concurrently, the company and the underwriter promote the IPO through a road show in which company officers make numerous presentations to ~mainly! institutional investors. A typical road show lasts three to four weeks and includes two or more meetings per day with both retail salespeople and institutional investors. As the road show progresses, the underwriter receives indications of interest from investors. However, regardless of the source of the indication of interest, at this stage, prior to the effective day, no shares can be officially sold, so any orders submitted are only indications of interest and are not legally binding.

7 An Examination of Trading in the IPO Aftermarket 1045 Table I Continued Major Stages and Main Events 4. Pricing and allocation Pricing; allocation Role of the Underwriter in the Main Events Once the registration statement has SEC approval, the underwriter files with the SEC an acceleration request, asking the SEC to accelerate the effective date of the registration statement. On the day prior to the effective date, the firm and the lead underwriter meet to discuss the offer price and the exact number of shares to be sold. Particular attention during the pricing decision is given to the order books. Shortly thereafter share allocation is decided. 5. Aftermarket activities Stabilization; overallotment option Research coverage Stabilization activities essentially require the underwriter to support the stock by buying shares if order imbalances arise. This price support can be done only at or below the offering price, and it is limited to a relatively short period of time after the stock has begun trading. Typically the underwriter sells 115 percent of the issue at the offering. If stock price goes up, it uses the overallotment option to cover the short position. If stock price goes down it covers the overallotment option by buying stocks in the open market. The final stage of the IPO process begins 25 calendar days after the IPO when the so-called quiet period ends. It is only after this point that underwriters ~and other syndicate members! can comment on the valuation and provide earnings estimates on the new company. ing the stock price. The overallotment option thus provides the underwriter with buying power in the aftermarket, enabling him to support the price of the newly traded security. The underwriter typically has 30 days to decide to exercise all or part of this option. The underwriter s use of the overallotment option is part of his larger responsibility to support the price of the issue. Price support refers to stabilizing bids, trades, and penalty bids made by the underwriter to influence the price by slowing price declines ~see Regulation M SEC release # , December 1996!. Although there is no legal restriction about the price level at which stabilizing trades can be made, stabilizing bids can be made only at or below the offering price. 7 Stabilization is intended to be temporary in nature, in order to facilitate the distribution of the securities, and typically only lasts for a short time period after the registration becomes effective. 7 For an excellent discussion of the revised legal restrictions ~Regulation M! on stabilization, see Aggarwal ~1998!.

8 1046 The Journal of Finance The final stage of the IPO begins 25 calendar days after the IPO when the so-called quiet period ends. It is only at this point that underwriters ~and other syndicate members! can comment on the valuation and provide earnings estimates on the new company. The SEC mandates this quiet period, and it marks a transition from investor reliance solely on the prospectus and disclosures mandated under security laws to a more open, market environment where research analysts interpret information, and provide estimates and recommendations to their clients regarding the new firm. An underwriter s role thus evolves in this aftermarket period into an advisory and evaluatory function. Despite the myriad activities in the offering process, the underwriter s compensation essentially comes from only two sources: fees and trading revenues. This paper focuses on examining the second source, the trading revenues. Of particular interest is whether the underwriter s aftermarket trading activities are a profit center or are subsidized by the underwriting process. II. Underwriting and Market Making in Initial Public Offerings We begin our analysis by examining the market making activity of the lead underwriter and the co-managers of initial public offerings. Our ability to analyze these activities derives from our use of a new and unique data set, and we first describe the sample of IPOs we use in our study and the properties of our data. A. Data and Sample We obtained an initial sample of 559 firm commitment IPOs, issued between September 27, 1996 and July 3, 1997, from the Securities Data Company ~SDC! new issues database. The SDC database includes offer date, amount issued, offer price, number of shares offered, management fees, and the lead underwriter and co-managers. 8 The proprietary nature of our data ~to be discussed below! restricts us to Nasdaq IPOs. Therefore, we exclude from our sample IPOs on the NYSE or AMEX, ADRs, offerings with units ~e.g., a stock plus a warrant!, REITs, closed-end funds, and IPOs on the SmallCap Market or on the OTC Bulletin Board. We also deleted one firm that was erroneously classified as an IPO. This left a final sample of 306 IPOs. As Table II indicates, the average offer size for firms in our sample is $37.2 million ~$41 million after the overallotment option exercise! which aligns closely to the average offer size of $35.2 for all IPOs on Nasdaq in The distribution of these offerings is skewed, with 251 offerings for 8 The SDC database also gives information on overallotment usage, but we found that their reported data are not accurate with respect to the actual takedown of the option. We therefore did not use these data but instead gathered data from each issuing firm s 10K and 10Q filings with the SEC.

9 An Examination of Trading in the IPO Aftermarket 1047 Table II Descriptive Statistics of Sample The sample is 306 Nasdaq IPOs from September 27, 1996 to July 3, The sample is split on offer amount excluding the overallotment option ~OAO! exercise, with small IPOs ranging from $5 million to $50 million; medium IPOs from $50 million to $100 million; and large IPOs from $100 million to $297 million. The offer price is the average price at which the IPOs were offered. Shares offered is the number of shares offered in millions excluding the OAO. Offer amount is the gross proceeds from the offering both excluding and including proceeds from the exercise of the OAO. The initial return is measured from NASD transaction data as the return from the offer price to the last trade of the IPO day. Panel B shows details about the underwriting fees. The number of observations drops to 301 IPOs due to missing data on lead underwriter fees. The gross spread is the total fee paid to underwriters in millions of dollars and as a percentage of the offer amount. Shares distributed by the lead underwriter is the percentage of shares allocated to the lead underwriter as reported in the prospectus. Lead underwriter fee is the portion of the gross spread allocated to the lead underwriter. It is the sum of the management fee ~which is only paid to the lead underwriter and co-managers!, the underwriting fee ~which we allocate solely to the lead underwriter!, and the selling concession on the lead underwriter s share of the offering. If there were co-managers, then half of the management fee is allocated to the lead underwriter. Whole Sample Small IPOs $5M $50M Medium IPOs $50M $100M Large IPOs.$100M Panel A: Description of Offering No. of IPOs Mean offer price $11.16 $10.20 $15.26 $16.09 Shares offered ~millions! Offer amount $37.2 M $25.8 M $64.9 M $148.9 M Offer amount including OAO $41.0 M $28.3 M $70.9 M $167.0 M exercise Initial return 11.0% 10.4% 12.3% 17.3% Panel B: Description of Fees Gross spread $2.57 M $1.82 M $4.48 M $9.64 M Gross spread incl. OAO exercise $2.83 M $2.0 M $4.89 M $10.81 M Gross spread ~% of proceeds! 7.10% 7.17% 6.91% 6.57% Shares distributed by lead 36.73% 38.15% 31.28% 28.17% underwriter ~no. of obs.! ~301! ~246! ~39! ~16! Lead underwriter fee ~no. of obs.! $1.34 M $0.98 M $2.22 M $4.66 M ~301! ~246! ~39! ~16! Lead fee incl. OAO exercise $1.47 M $1.08 M $2.43 M $5.24 M ~no. of obs.! ~301! ~246! ~39! ~16! Lead underwriter fee ~% proceeds! 3.90% 4.02% 3.45% 3.17% ~no. of obs.! ~301! ~246! ~39! ~16! amounts between 5 and 50 million, 39 for amounts between 50 and 100 million, and 16 for amounts over 100 million. The average offer price in our sample is $11.16, which is slightly above the 1996 average IPO price of $ The IPOs in our sample occurred regularly throughout our sample period. As

10 1048 The Journal of Finance is typically the case with IPOs, the firms in our sample experience substantial gains on the offer day. The initial return measured from the offer price to the last trade on the first trading day averages percent. 9 For each firm in our sample we then obtained transactions data from a proprietary database provided by the NASD Economic Research Department. These transaction data provide the time, price, and volume for each trade, as well as a code identifying both parties involved and an indicator that tells us who was buying and who was selling. The data also include all quote revisions for all market makers in each stock. Thus, we have full quote schedules at all times for all of the stocks, with each quote identified by the market maker who set that quote. We can track the behavior of the lead underwriter and other market participants by using the code identifying the name of the market maker setting a quote or the trader involved in the trade. There are three classifications of market participants corresponding to the level of access that each participant has to the Nasdaq market. There are market makers: ~i! firms registered to set quotes for the stock on a given day ~e.g., Merrill Lynch, BT Alex Brown!; ~ii! order entry firms: NASD members who are not market makers in the stock but who can enter orders for the stocks either directly with a market maker via SelectNet or via one of the Electronic Communications Networks ~Instinet, Island, B-Trade, or Terra Nova!; and ~iii! non- NASD members, or customers, who cannot trade directly on the Nasdaq but must trade via a market maker or an order entry firm. We have precise identities for the participants in the first two categories; for the third type of participant the code in our data is blank. 10 B. Who Underwrites IPOs? Each of the IPOs in our sample is brought to market via a firm commitment underwriting. This process involves a lead underwriter ~the book manager!, sometimes one or more co-managers of the offering, and a large syndicate of investment banks that aid in the distribution of shares. For the 306 IPOs in our sample, there are 80 different lead underwriters. Table III reports the number of IPOs underwritten by the top 15 investment banks ~in terms of the frequency of the offering!. Leading the pack is Montgomery Securities, which was the book running manager for 27 IPOs with an average deal size of $36.3 million, followed by Alex Brown with 19 IPOs, and Goldman Sachs with 16. Not surprisingly, the average deal of the bulge- 9 This level of underpricing is consistent with previous underpricing noted by numerous authors ~see Ibbotson and Ritter ~1995! for a survey!. 10 During this period, the SEC introduced the new order-handling rules that allow for the public display of limit orders. These rules were initially extended to a subsample of the largest Nasdaq firms, and so did not apply to the firms in our sample. Consequently for most of the stocks during our sample period it was not possible for customers to transact directly with market makers. Currently, it is possible for customers to submit limit orders, and spreads have fallen as a result. This suggests that trading profits for the underwriter may now be lower than they are in our sample. For a discussion of these changes see Schultz ~1997! and Barclay et al. ~1998!.

11 An Examination of Trading in the IPO Aftermarket 1049 Table III Frequency of Investment Banks as Underwriters This table provides the underwriting frequency of the 80 lead underwriters in our sample of 306 Nasdaq IPOs from September 27, 1996 to July 3, The third column gives the average deal size ~excluding the overallotment option exercise! in millions of dollars for each investment bank. Underwriters of at least 6 deals are listed individually; the other 65 underwriters are grouped together in the second to last row. Investment Bank Number of IPOs Underwritten Average Deal Size ~$M! Montgomery Securities Alex Brown Goldman Sachs Cowen Hambrecht and Quist Friedman, Billings, Ramsey Smith Barney Shearson Morgan Stanley Lehman Brothers Donaldson, Lufkin and Jenrette CS First Boston UBS Securities Bear Sterns Piper Jaffrey Robertson Stephens others ~5 or fewer deals each! Total 306 bracket ~top-tier! firms is much larger than that of the other investment banks: Goldman s average deal size is $79.4 million, Morgan Stanley s is $66.8 million, and CS First Boston s is $76.5 million. Although the majority of underwriting business is concentrated in 15 investment banks, which underwrite at least six IPOs each, most investment banks act as lead in only a few offerings, with 65 underwriters underwriting fewer than six IPOs. The average number of co-managers in our sample is 1.32, with the majority of offerings ~254, or 83 percent of the sample! having one or two co-managers. Thirty-five IPOs do not have any co-managers. 11 C. Who Makes Markets in IPOs? Who exactly makes markets in newly issued securities? For the purposes of our study, an obvious starting point is to determine the role of the underwriter in market making. Here an interesting result emerges: in every IPO, the lead underwriter always acts as a market maker. To gauge the importance of the underwriter as a market maker, it is important to investigate 11 In all of these cases the lead underwriter is a regional rather than a national investment bank.

12 1050 The Journal of Finance what, if any, role is played by other market makers. NASD rules allow dealers relatively free entry to make markets in stocks, so the number of dealers can vary considerably across stocks. Exit from market making is also relatively unconstrained, and changes in the population of dealers in a particular stock are very common. We calculate the average number of market makers for each IPO over the first three months of trading. For our sample as a whole, there are on average just under 10 ~9.95! market makers quoting bid and ask prices on the offering day. The number of dealers varies with the size of the offering, ranging from 9.55 dealers on the first day for issues below $50 million, to 12.3 dealers on the first day for offer amounts greater than $100 million. 12 The average Nasdaq stock in 1996 had 9.5 market makers, and so our IPO stocks seem quite typical. When we adjust for size, however, it is clear that IPOs have far more dealers than is typical. The 317 Nasdaq stocks with three or fewer market makers in 1996 had an average market value of $56 million, and the 1657 stocks with three to five market makers had an average capitalization of approximately $93 million. 13 Finally, each IPO is losing about three market makers in the first three months of trading. This is consistent with a clientele effect among dealers in which some dealers make markets in the first active days of an offering and then permanently leave the market. Given that the lead underwriter is only one market maker with nine other market makers on the first day of trading, we need to determine the relative importance of the market makers. Figure 1 and Table IV show that the lead underwriter takes a very significant role in the aftermarket market making activity. Figure 1 depicts the daily average turnover per IPO, calculated as shares traded as a percentage of the shares offered in the IPO. The turnover is extremely high on the first day: an average of 61.9 percent turnover in one day. By way of comparison, this is equal to approximately one-third of the average annual stock turnover on the Nasdaq in The trading volume drops dramatically after the first day. The average turnover on day 60 is 2.0 percent, which it is still higher than a typical Nasdaq stock s daily turnover. Figure 1 also shows the cumulative order imbalance, calculated as the share volume due to sell classified trades minus the share volume due to buy classified trades, reported as a percentage of the shares offered in the IPO. The order imbalance is positive, suggesting that there is more sellinitiated volume in IPO trading than buy-initiated trading, and it is on the order of 10 percent of the issue on the first day of trading. The order imbalance accumulates for the first four days, suggesting strong seller-initiated trade. Beyond the first week of trading, the cumulative order imbalance 12 Statistically, there is no significant difference in the number of market makers across the different size groupings. 13 Information on the Nasdaq market is taken from the 1996 Nasdaq Fact Book. 14 According to the 1997 Nasdaq Fact Book, the average annual turnover on the Nasdaq in that year was 181 percent.

13 An Examination of Trading in the IPO Aftermarket 1051 Figure 1. Mean daily turnover, cumulative order imbalance, and the lead underwriter s fraction of trading. The average daily turnover is shown for the sample of 306 IPOs. Average daily turnover is measured as the number of shares traded as a fraction of the number of shares offered in the IPO ~not including overallotment shares!. The cumulative order imbalance is the cumulative sell-initiated volume minus the cumulative buy-initiated volume, as a fraction of the shares offered in the IPO. Buy0sell direction is given directly in the NASD transactions data for 80 percent of the trades, and the Lee and Ready ~1991! algorithm is used for the remaining 20 percent. The lead underwriter s trading volume is the number of shares traded by the lead underwriter as a liquidity provider, as a fraction of the total daily trading volume. The lead underwriter is a liquidity provider in a trade when he sells ~buys! in a buyer ~seller! initiated trade. remains flat, as the daily order imbalance is less than one percent of the shares issued. The order imbalance suggests that liquidity providers will on average be net buyers of IPOs. To examine the trading volume of the market makers we need to consider the passive side of trading: market makers acting as liquidity providers. The third line in Figure 1 shows the fraction of the trading volume where the lead underwriter acts as a market maker. On the first day, for example, the lead manager assumes 58.8 percent of the trading volume. The lead manager s share of the trading volume slowly declines, but it still remains greater than 40 percent even three months after the IPO has begun trading. Table IV provides the trading volume of all the liquidity providers, given both as fractions of the daily trading volume, and in thousands of shares. The table shows that the lead underwriter s percentage of the trading volume decreases gradually, but in terms of his number of shares the decline is drastic plummeting from million on trading day 1 to 81,000 shares on day 5 and to 27,000 on day 60. We also find that 95 percent of the co-managers in our sample ~1.25 comanagers per IPO! make a market in the issue, although their activities in

14 Table IV Trading Volume in the First Three Months after an IPO This table shows the trading activity of the liquidity providers in the first three months of trading after an IPO. Panel A examines all types of liquidity providers and shows the trading volume in thousands of shares and as a percentage of total volume for four categories of liquidity provider: the lead underwriter for the IPO, co-managers, unaffiliated market makers, and order entry firms. Unaffiliated market makers are NASD registered market makers for the IPO that are not the managers of the deal. Order entry firms are NASD members who can provide liquidity by placing limit orders on an electronic communications network, but are not market makers for the stock. The sample is 306 Nasdaq IPOs and averages are calculated per IPO, rather than per trader. We use the trader identities from the NASD transactions database to categorize trades by liquidity provider. Panel B focuses on the lead underwriter s activity as a market maker, splitting the sample on initial return ~the last trading price on the offer day minus the offer price!. Daily turnover is the average total volume per IPO given as a percentage of the shares offered. The fraction of trading volume done by the lead underwriter is given as a percentage and in number of shares. Panel A: Trading Volume by Liquidity Providers Lead Underwriter Co-Managers Unaffiliated Market Makers Order Entry Firms Volume ~%! Shares ~000s! Volume ~%! Shares ~000s! Day Day Day Day Day Volume ~%! Panel B: Lead Underwriter Trading Volume, by IPO Performance Shares ~000s! Volume ~%! Shares ~000s! 1052 The Journal of Finance Daily Turnover ~% of shares! Initial Return 0% ~n 24! 0% ~n 55! 10% ~n 104! 10% ~n 123! Volume ~%! Shares ~000s! Daily Turnover ~% of shares! Volume ~%! Shares ~000s! Daily Turnover ~% of shares! Volume ~%! Shares ~000s! Daily Turnover ~% of shares! Day Day Day Day Day Volume ~%! Shares ~000s!

15 An Examination of Trading in the IPO Aftermarket 1053 this regard are rather limited. On average, co-managers handle 8.7 percent of the trading volume on the first day and 21.5 percent of the trading volume after three months of trading. Besides the lead underwriters and co-managers, there are on average 7.7 other market makers per IPO on the first day of trading. Their share of the volume remains around 30 percent of the daily volume throughout the first 60 trading days. Order entry firms handle an insignificant portion of the daily trading volume. Finally, we also examine the dominance of the lead manager conditional on the IPO first-day performance. This is of particular importance for investigating the role of stabilization in market making activity in the post- IPO time period. The results are presented in Panel B of Table IV for four performance categories: those IPOs that experience negative first-day return ~24 IPOs!, those with a zero return ~55 IPOs!, IPOs with a first-day return between zero and 10 percent ~104 IPOs!, and IPOs with a return greater than 10 percent ~123 IPOs!. Though the trading volume of the hot IPOs is more than double that of the other IPOs, the share of trades by the lead manager is almost the same hovering around 58 to 60 percent of the trading volume. There does not seem to be any distinct pattern in the share of the lead volume across IPOs with different performance. In summary, we find that the underwriter always becomes a market maker in an IPO, along with an average of nine other market makers. The underwriter handles the lion s share of the trading volume both for the successful and less successful IPOs. Given the trading dominance of the lead manager, it is quite likely that he will also be the one accumulating most of the order imbalance, an issue we analyze in more detail in the next section. III. The Aftermarket Trading of IPOs We now turn to the issue of how much inventory risk is taken by the underwriter and other market makers. Because our data set gives the price, size, and time of each trade identified by buyer and seller, we can determine the exact trades of each market maker for each IPO in our sample. This allows us to calculate the inventory position of every market maker, as well as his trading profits and losses. In this section, we focus on the inventory positions, with particular attention given to how the IPO price performance, the impact of stabilization, and the overallotment option affect the underwriters trading positions. In the next section, we focus on the overall profitability of trading and underwriting activities. A. Market Makers Inventory We begin our analysis by calculating the inventory positions taken by market makers for the 306 IPOs in our sample. For each market maker we B calculate the number of shares bought on day t, N B ~t! ( t j 1 N B ~ j!, where B t is the number of buy trades for the market maker on day t, and N B ~ j! is

16 1054 The Journal of Finance the number of shares bought in the jth trade, at price P~ j!. Similarly, the S number of shares sold is N S ~t! ( t j 1 N S ~ j!. The change in inventory position on day t is the market maker s trading imbalance: INV~t! N B ~t! N S ~t!. ~1! The market maker s cumulative inventory position at the close on day t, INV~t!, is the sum of the opening inventory on day t and the change in inventory over the day: INV~t! INV~t 1! INV~t!. ~2! Table V reports the mean and median inventory of the lead underwriter, as well as the mean inventory of the co-managers, and market makers unaffiliated with underwriting the IPO throughout the first 60 trading days. 15 What is immediately striking is the large inventory position taken by the lead underwriter on the offer day. On average, the lead underwriter buys back 3.77 percent of the offering on the first day ~109,000 shares!. The underwriter continues to buy stock heavily over the first week, reaching an inventory position of 6.21 percent of the offering by the end of the first week of trading. After 20 trading days, the market maker has bought 7.82 percent of the offering on average, and over the next 40 trading days his position recedes slightly to a 7.56 percent inventory position. This latter behavior is consistent with the underwriter supporting the stock only for about 20 days after the offer date. However, the large differences between the means and medians suggest evidence of outliers; this dictates caution in interpretation of the data at this stage. We address this problem in the next section when we adjust the lead underwriter s inventory position for the overallotment option. The co-managers in the underwriting play virtually no role in the aftermarket inventory accumulation and price support of the issue. On the first day, the co-managers acquire in inventory only 0.07 percent of the issue on average. Hence, although a co-manager may play an important role in the distribution of the offering, his role in the aftermarket activity is negligible. This limited role continues throughout the first 60 trading days of the issue. The role of the other market makers in trading the new issue is also extremely limited. Again, on average, each market maker acquires just 0.10 percent of the issue on the offer day. As a group, this amounts to only 0.77 percent of the issue as there are 7.7 unaffiliated market makers per IPO on the first trading day. By day 60, the role of the other market makers is even smaller than on the offer day. 15 The sum of all the market makers inventories does not add up to the order imbalance in Figure 1 because of trade between market makers. The order imbalance in Figure 1 is the total order imbalance, whereas the sum of all the market makers inventories equals only the order imbalance due to trades with non market makers. Trade between market makers nets to zero in the market makers inventories.

17 An Examination of Trading in the IPO Aftermarket 1055 Table V Market Makers Inventory Position This table shows the cumulative inventory positions for the market makers, calculated as INV~t! INV~t 1! INV~t! where INV~t! N B ~t! N S ~t! is the change in inventory on day t due to trading. N B ~t! ~N S ~t!! is the number of shares bought ~sold! on day t, and INV~t 1! is the inventory carried over from the previous trading day. The sample is 306 Nasdaq IPOs from September 27, 1996 to July 3, There are three market maker categories: the lead underwriter, co-managers, and unaffiliated market makers. The mean inventory position is given for each category ~and the median is given for the lead underwriter!. For the co-managers and unaffiliated market makers, the mean and median are per dealer. The number of unaffiliated market makers changes across trading days, and the average number of observations per IPO is given for the unaffiliated market makers. The average inventory position per IPO for co-managers and unaffiliated market makers can be calculated by multiplying the mean inventory position per market maker by the average number of market makers. The inventory position is reported in thousands of shares and also as a percentage of the shares offered in the IPO. This is the inventory position divided by the number of shares in the offering ~not including the overallotment option!. Market Maker Lead Underwriter Co-Managers ~1.25 obs. per IPO! Unaffiliated Market Makers Mean Median Mean per Co-Manager Mean Obs. per IPO Mean per Market Maker Cumulative inventory in thousands of shares Day 1 109*** 44*** 3* *** Day 5 176*** 97*** 3* *** Day *** 123*** *** Day *** 127*** 8*** ** Day *** 121*** 12*** Cumulative inventory as percentage of shares offered Day *** 1.54*** 0.07* *** Day *** 3.66*** *** Day *** 4.21*** *** Day *** 4.54*** 0.21** Day *** 4.56*** 0.29*** *, **, and *** indicate that the entry is significantly different from zero at the 10, 5, and 1 percent levels, respectively, under a t-test for the mean, and a Wilcoxon signed rank test for the median. That the lead underwriter takes on a substantial inventory position on the first day of the offer is an interesting, but perhaps not unexpected, result. Implicit in the underwriting process is the guarantee of price stabilization, and this would require the market maker to purchase the stock if the price would otherwise fall. This suggests that inventory accumulation by the underwriter gives a direct measure of price stabilization activities. Specifically, while simply buying and selling securities over the course of a trading day is not unusual for any market maker on any stock, accumulation of a significant inventory position is. For example, it is possible for the lead manager to post the inside bid ~and ask! and not to accumulate inventory. But

18 1056 The Journal of Finance stabilizing prices requires the lead underwriter to intervene in the market in ways that he otherwise would not, and this results in accumulating inventory. Inventory accumulation thus gives a direct perspective on his price stabilization activities. 16 Many IPOs experience large price gains however, negating any need for market maker purchases. This suggests the hypothesis that the inventory position of the lead underwriter depends on the subsequent return of the IPO, with greater purchases the lower the trading price relative to the offer price. To test this hypothesis, we stratify our sample into three categories based on the frequency with which the IPO has been trading above and below the offer price in the first 20 days of trading. The first subsample contains all IPOs that traded strictly above the offer price ~153 hot IPOs!, the second subsample contains those IPOs that traded both above and below the offer price ~139 tepid IPOs!, and the third subsample contains those IPOs that traded only at or below the offer price in the first 20 days ~14 cold IPOs!. Figure 2 demonstrates the dramatic effect of the trading range on inventory accumulation. While the average first-day inventory position is 3.77 percent, the position across the subsamples varies from 0.4 percent for the hot IPOs to 15.6 percent for the cold ones on the first day. That is, the poorer the performance of the IPO, the more shares the lead underwriter accumulates. After 60 days of trading, the underwriter has accumulated only three percent of the offering for the hot IPOs, but 16.5 percent and 11.7 percent for the cold and tepid IPOs respectively. Using the relationship between inventory accumulation and price stabilization, we can also calculate the length of the price support period. For the group of IPOs that consistently trade below the offer price, the inventory peaks at day 21. In other words, since price support is directly reflected in the inventory position, for these stocks price support lasts for 21 days on average. After that, the level of inventory declines, suggesting that not only does the underwriter stop buying to support the price but he also attempts to reduce his inventory exposure by selling. For the overall sample, price support lasts on average for 15 days, as can also be seen from Figure The differences in the inventory position between the hot, cold, and tepid 16 There are, of course, other ways to examine stabilization and to measure its impact. Schultz and Zaman ~1994! consider the fraction of time the underwriter sets the inside bid as evidence of stabilization, while Hanley et al. ~1993! focus on changes in the time-series pattern of prices to determine when stabilization ends. We look at inventory changes because they allow us to observe direct provision of liquidity, which should be complementary to the analyses noted above. 17 Factors other than return may also affect the underwriter s inventory position. The reputation of the underwriter may impact his market making activity; highly reputable underwriters may be more active in the aftermarket than less reputable underwriters, resulting in higher inventory positions. The offer size may affect the underwriter s inventory as the underwriter faces capital constraints and may not be able to buy the same amount of a large issue as of a small issue. Another factor may be the first day s turnover of the issue, as it is generally the case that hot issues have greater volume than do cold offerings. However, none of these hypothesized effects appear strongly in the data.

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